OREANDA-NEWS. Fitch Ratings has revised the Outlook on Malaysia-based conglomerate Sime Darby Berhad's (Sime Darby) Long-Term Foreign and Local Currency Issuer Default Ratings (IDR) to Negative from Stable. The IDRs and the company's senior unsecured rating are affirmed at 'A'. Fitch has also affirmed the rating on the company's USD1.50bn sukuk issue at 'A'.

The revision in the Outlook to Negative follows a sharp increase in Sime Darby's FFO-adjusted net leverage to about 2.50x in the first half of the financial year to 30 June 2015 (FY14: 1.52x), well above the 1.75x level at which Fitch would consider negative rating action. While Fitch expected the increase in leverage after the debt-funded acquisition of New Britain Palm Oil Limited (NBPOL), the agency now estimates that the deleveraging process will take longer than initially expected due to the weaker than expected performance of Sime Darby's industrial equipment business and higher net debt to fund the property development business. Given the weak commodity environment, Sime Darby's industrial equipment business will continue to face challenges over the short to medium term.

KEY RATING DRIVERS

Weak Industrial Division Performance: EBIT in Sime Darby's industrial division declined by 46% to MYR316.2m in 1H FY15 due to the continuing weakness in the Australian mining sector, which resulted in lower equipment deliveries and lower margin from product support sales. Profit in its Malaysia and Singapore operations also fell due to lower equipment and engine sales due to the slowdown in the construction, mining and shipyard sectors, while in China and Hong Kong, profit improved due to better margins from equipment deliveries. Commodity prices continued to fall to near marginal production cost, resulting in intense pressure on the product support business.

Deleveraging Initiatives: Sime Darby proposes to engage in capital management initiatives that could include the listing of its motor division by end-FY16, which, if successful, would result in financial leverage declining towards Fitch's negative trigger of 1.75x.

Also, a significant proportion of Sime Darby's shareholders have opted for its dividend reinvestment plan (DRP), which reduced cash dividends paid by 23% to MYR1.57bn in FY14. Of the MYR1.80bn final dividend declared for FY14, only MYR505m (28% of dividends declared) was paid in cash. While Fitch expects Sime Darby to maintain its dividend payout ratio at about 50%, the cash payout is likely to decline due to the success of the DRP, which would help to reduce leverage.

Debt-funded Acquisition: Sime Darby debt-funded the acquisition of a 98.84% stake in the Papua New Guinea-based oil palm company NBPOL for MYR5.70bn. NBPOL has a land bank of 135,000 hectares, 12 oil mills and two refineries - one in PNG and the other in Liverpool, UK. This acquisition has resulted in an increase in Sime Darby's land bank by 16% and improved Sime Darby's capabilities to deliver oil palm products to Europe.

Low CPO Prices Sustained: Robust CPO output in Malaysia and Indonesia driven by improved productivity, a bumper soybean crop that has narrowed the differential between soybean oil and CPO prices, and a low crude oil price (to which CPO is closely correlated as CPO is a bio-diesel input) has resulted in sustained low CPO prices.

As Sime Darby is an integrated low-cost CPO operator, its downstream division benefits from declining input costs. But this is not adequate to offset the price decline. Fitch believes that the company will tide over this period of low prices, but margins - in US dollar and per metric ton terms - would remain depressed in the next 12 to 18 months.